Bitcoin - A Digital Currency

Posted by Hans de Ruiter

Bitcoin is a digital currency that is designed to work like cash. I first heard about it in the June 2012 edition of the IEEE Spectrum magazine. The idea of a digital currency that was not centrally controlled and worked like cash intrigued me, and the fact that it appeared in the primary magazine of the Institute of Electrical and Electronics Engineers added credibility. So, I decided to check it out.

How BitcoIn Works in Brief

Bitcoin is built primarily on two technologies: peer-to-peer networking, and cryptography. Peer-to-peer networking ensures that the system is fully decentralised, so that no one central authority can control it. Cryptography makes sure that transactions can be both ananymous (like cash), and secure. I'll explain the basics here. Those who want the technical details can go here.

Mining for Bitcoins

A Bitcoin miner is a computer/machine that calculate cryptographic hashes to validate blocks. Miners are rewarded for creating valid blocks with a set amount of Bitcoins (currently 50), and any transaction fees in that block. The difficulty level of validating blocks is adjusted such that valid blocks are created at a set rate. This is done so that no-one can print money, and it is also the basis by which the Bitcoin network is kept secure.

There is a catch with the mining; only the miner that finds the solution earns the 50 Bitcoins for that block. The more processing power that a miner has, the more likely it is that he/she will get the reward.

This process might sound strange, but it will become clear later.

Sending and Receiving Money

Each Bitcoin user has a wallet containing their Bitcoins. These coins are transferred between one user and another via public and private keys (of which each wallet can have many). To send money to another user, a transaction is created to one of their public keys (a.k.a., an address), and is signed by the sender using a private key. Only the sender knows the private key, but everyone else can use the public keys to verify the transaction.

At this point, the Bitcoin miners come into play. Transactions are assembled into blocks every ten minutes, and the miners validate each block, and add it to an ever increasing block-chain. This locks the transactions into place. If some nasty person wanted to change a transaction (e.g., to redirect the money to their pocket, or spend money twice), they would have to revalidate not only the block containing the transaction, but every block that has been validated since then. Thanks to the sheer size of the total processing power of all miners in the Bitcoin network, the processing power required to achieve this is so immense, as to be almost completely impossible. Hence, the transactions are irreversible, anonymous, and yet the system is secure (unless someone can control huge amounts of processing power).

How Can I Become a Bitcoin Miner?

Woah there, slow down a bit. Yes, it sounds like a dream come true to be able to earn money simply by running a computer program. However, remember how I said that the difficulty level for validating blocks (and hence, earning Bitcoins) is adjusted to keep block production constant? Well, there are lots of others with exactly the same idea, so the cost of mining tends (i.e., the cost of the hardware and electricity) to be at or just above the amount earned.

Bitcoin mining is very competitive. Initially, a powerful CPU was enough, then as more miners joined in, powerful GPUs were required. Now, it's more cost-effective to use FPGAs, and soon, ASICs will provide an even more energy efficient way to mine. It is unlikely that you will earn much of anything by yourself.

How do I Use Bitcoin?

First you need to download a Bitcoin client. I suggest using something like MultiBit, as it's faster than the original client. Next, you need to put some coins into your new wallet. There are a few places where you can get some free (micro) Bitcoins; just search for "free Bitcoins" on the internet. Or, you can do things the normal way, and use a Bitcoin exchange to transfer money from standard currencies - such as dollars - to Bitcoins. These currency exchanges are bidirectional, so you can also exchange Bitcoins back to your local currency.

Is Bitcoin Worth Using?

I'm not 100% convinced that it is worth using yet. There are some advantages:

The currency is decentralised, so no one central authority can take control

Since there is no central authority, transaction fees are lower

Transactions are as anonymous as cash

Transactions are irreversible (i.e., no credit-card charge reversals, which is good if you're the seller)

but, there are also disadvantages:

Transactions take approx. 10 minutes to be validated

If someone can hack into your computer they might be able to steal your coins remotely (NOTE: This risk can be minimised by encrypting your wallet)

Transactions are irreversible (bad, if you're a buyer who has been scammed)

The anonymity can be abused by those with low moral and ethical standards (just like physical cash)

The more people who use the currency, the more useful it becomes. Right now, the number of Bitcoin users is steadily increasing, and it looks like it could reach critical mass. Real transactions are taking place, and real items are being bought using this currency. However, there are no guarantees. Maybe it will become widely accepted; maybe something else will take its place. Or, maybe governments and financial institutions will try to shut it down because they can't control it. Who knows? Nothing is without risk.

For now, I'll say that it is an interesting idea that looks like it has a good chance of succeeding. It's definitely something worth keeping an eye on.

P.S., If you want to test out sending money using Bitcoin, you can donate some to me via this address: 1kCb9s1NtrzxkeYELxHM9DGezp8SEz1ZV